Justices Aren't Interested in Insider Trading Case

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
Read More.

The big insider trading news today is more of an absence of news: The Supreme Court will not review the U.S. v. Newman decision, which held that you can't be guilty of insider trading based on leaked inside information if (1) the person leaking the information didn't get a "personal benefit" in exchange or (2) he did, but you didn't know about it.

We've talked about this case a lot, but here's a quick recap, none of which is legal advice. First: Insider trading is not about fairness; it's about theft. It's not always illegal to trade on material nonpublic information, but it is illegal to trade on material nonpublic information in violation of a duty to the owner of the information. (Typically, that's the company whose stock you're trading.) If an executive sells some stock ahead of a negative earnings surprise, or tells his brother-in-law to buy shares before a merger that's about to be announced, that's bad. But if a company's chief financial officer meets with a big mutual fund to answer questions and try to persuade it to invest in the company, that's not insider trading, even if a few secrets are disclosed in the meeting. The company is the owner of the information, and if it knowingly gives it to you, you can trade on it.

This can be a squishy thing to measure, and the Supreme Court came up with a reasonably workable test:

To determine whether the disclosure itself "deceive[s], manipulate[s], or defraud[s]" shareholders, the initial inquiry is whether there has been a breach of duty by the insider. This requires courts to focus on objective criteria, i.e., whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.

That's from a 1983 Supreme Court case called Dirks v. SEC (emphasis added and citations omitted). The idea is that if you're an insider and you disclose information for your own personal benefit, or just trade on it yourself for profit, then that sure looks like a breach of duty to your company. But if you don't get a personal benefit from the disclosure, then odds are that you're doing it for some legitimate, or legitimate-ish, business reason. It might be a misguided business reason, or one that the company doesn't like -- in Dirks itself, the insider was disclosing fraud to an investment analyst -- but it's probably not the sort of corrupt breach of duty that the law punishes.

In the years since Dirks, though, courts had stopped taking this personal benefit test seriously. The personal benefit test, after all, doesn't make any sense, if you think that insider trading is about fairness. It isn't, but people kind of want it to be, so the law kept expanding. And so Todd Newman and Anthony Chiasson were convicted of insider trading in part because an investor relations employee at Dell gave a mutual fund analyst some help with his Dell financial model, and that analyst passed on the information to other analysts, who passed it on to Newman and Chiasson. Helping mutual fund analysts with their financial models is of course precisely the job of investor relations, there was lots of evidence that Dell did it all the time, and there was no evidence that the employee was bribed or anything for his tips. (He got some vague career advice.) But it sounds unfair to jurors: Nobody at Dell is helping them invest. And Newman and Chiasson were rich hedge fund managers who made a lot of money on information that is not available to retail investors. So, sure, throw 'em in jail.

But the Court of Appeals for the Second Circuit threw out their convictions, holding that prosecutors needed to prove that the tipper got a personal benefit (he didn't), and that Newman and Chiasson knew about it (they didn't). This is pretty much exactly what the Supreme Court said 30 years ago in Dirks, so it was strange that prosecutors asked the Supreme Court to review it, and unsurprising that the Supreme Court turned down the request.

Now you could have a little sympathy for the prosecutors here. The language in the Second Circuit's opinion is notably baffling, and prosecutors seem to have appealed mostly to clarify it. If you read it too literally, it also seems wrong: It seems to say that, if a corporate insider tips his brother or golf buddy with the intention that the brother/buddy will trade on the tip and make money, that's not illegal insider trading, because the insider himself didn't get any direct quid pro quo for the tip. And if Newman does make it impossible for prosecutors and the Securities and Exchange Commission to stop that sort of insider trading, that does seem kind of weird, right? Here's U.S. Attorney Preet Bharara today:

“The Newman decision was wrong,” Bharara told reporters. "You can think of it as a potential bonanza for friends and family of rich people who have access to material nonpublic information.”

And:

Now, Bharara said, federal prosecutors will “have to think long and hard” about whether to bring a case against an executive who leaks data about earnings “or anything else of a very sensitive nature” to “a relative or a buddy or a crony knowing absolutely that the person is going to trade on it.”

But that doesn't seem to actually be true. Since Newman, the SEC and the courts seem to have concluded that if the tipper intends to benefit the recipient of his tip, that's good enough to create criminal liability, even under the Newman standard. A personal benefit for the tipper can include "the benefit one would obtain from simply making a gift of confidential information to a trading relative or friend," as the Second Circuit said itself in Newman, and the golf cases are proceeding apace. There is some awkward language, but Newman does not actually seem to stop prosecutors from going after relatives, buddies or cronies.

Here's what it does do: It makes it hard for prosecutors to go after unfair use of information by professional investors. Newman, after all, didn't involve relatives, buddies or cronies. It involved hedge fund managers using information that they got from their analysts, who got it from other analysts, who got it from company employees with whom they had more or less professional relationships. The prosecutors' theory in Newman was that, if you are a professional investor, and you have really good nonpublic information about a company's finances, then that alone means that you are guilty of a crime.If you have good information, and no one else has it, then trading on it is a crime, even if you have no idea where it comes from.

That is a rough standard for professional investors! Their job, after all, is to try to figure out information about companies that no one else has. That's how they make money, and also how they make markets efficient and prices correct and capital well-allocated and all that good stuff. So the professional investors want their information to be good information. But prosecutors don't want it to be too good. That is a hard balance to find, if you are a professional investor, and if you get it wrong you go to prison for years.

The Second Circuit decision in Newman, for all its convoluted language, actually makes things clearer and simpler for professional investors. The upshot, I think -- and this is especially not legal advice -- is, first of all, that you can trade on information unless you know, or at least have reason to know, that it was obtained illegally. But second, it narrows what it means for the information to be obtained illegally. In particular, it seems to me that information shared in the context of a basically businesslike relationship gets the benefit of the doubt. If you're talking to people at a company as part of your job as an investment analyst and their jobs as investor relations people, you're probably fine, even if you also sometimes chat about your vacations or look over their resumes. If you just bribe them for inside information, that's bad. But even if you do that, your manager isn't guilty of insider trading unless he knew about the bribes. Your manager can just ask you to get good information, and then trade on that information, without worrying that if it's too good he'll go to prison.

This is good for predictability, and probably for efficient capital allocation and so forth. It is bad for fairness. I mean, you can see the appeal of a standard that says: If you have good information that isn't public, then trading on it is a crime. Why should you trade on information that no one else has?

One answer might be: because that is your job. One way to read Newman is as a recognition that getting information about companies is a job, and that it works kind of like other jobs. Like sales, for instance. Which investors are going to get the best information from company executives and investor relations departments? Well, big investors have more money, so companies will want to talk to them more. Investors with a history of treating management well might charm companies into disclosing information; investors with a history of fighting management to the death might scare companies into disclosing information. Investors who ask better questions will get better answers than those who ask worse questions. Investors who are charming -- who chat up investor relations people, listen to their troubles, help them with their resumes -- will have an advantage over those who are not. Investors who straight up bribe investor relations people with bags of cash will have an advantage, sure, but in the same way that salespeople who straight up bribe buyers with bags of cash have an advantage. That is: in a way that is illegal and probably not all that common.

Of course it is unfair that Carl Icahn or Fidelity or whoever can meet with the chief executive officers of companies that they invest in, and you can't. But it's unfair in the same way that, like, a salesman for Xerox can meet with big companies to try to sell them copiers, and you can't get those meetings to try to sell the hand-cranked copier you built in your garage. Lots of businesses reward past success, and a history of customer service, and intelligence, and preparation, and sure, also, charm and salesmanship. And companies have lots of good reasons to meet with investors. They certainly do a lot of it!

If I'm right that Newman won't stop amateur insider trading prosecutions, but will give professional traders the benefit of the doubt, then, sure, that will damage Bharara's legacy of prosecuting professional traders. More fundamentally, though, it might finally kill the notion that insider trading law is about a level playing field between amateur and professional investors. That notion has never made any sense, but it has gotten a lot of lip service from prosecutors and the SEC. The Second Circuit's Newman opinion, though, takes a much clearer view of the fact that professional investors get information in a variety of ways, including by talking to companies, and doesn't get too exercised about the fact that these opportunities are not available to retail investors.

In fact, not only did the court allow this unfairness to continue, it also created another advantage for professionals: Newman made it harder to prosecute professionals for insider trading (by insulating business relationships and requiring knowledge of personal benefits), but doesn't seem to have cut down on the prosecutions of the usual amateur golf-buddy insider traders. In the law, as in investing, the big guys always have an advantage.

Also, it is not at all points an orthodox statement of the law. The idea of insider trading as theft is perhaps not standard, and this discussion elides the difference between "classical" and "misappropriation" insider trading and treats the personal benefit test as primarily an evidentiary standard to prove breach of fiduciary duty.

Not always. For instance, if Company A is planning to buy Company B, and hasn't told Company B yet, Company A can be the owner of the information even though the trading would be in Company B stock. There is a story like this involving Berkshire Hathaway. (It was Company A.)

Or if Pershing Square is planning to mount a big short campaign against Herbalife, and you steal that information from Pershing and trade on it, that might be illegal insider trading -- even though of course it's legal for Pershing Square to trade on the knowledge of its own intentions. (How could it not be?)

Very important note: If the company tells you something material and nonpublic, intending that you trade, and you trade on it, that's probably not illegal insider trading. But it probably is a violation of Regulation FD, which says that companies can't do that. But that's the company's problem, not yours. And enforcement of Regulation FD seems to be a lot more chill than enforcement of insider trading law. It's almost like the authorities think that the information belongs to the company, and that it can do what it wants with it.

The question presented is whether the court of appeals erroneously departed from this Court’s decision in Dirks by holding that liability under a gifting theory requires “proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”

I mean yeah that is weird stuff.

I thoughtthis when the Newman decision came out. I don't think I think it any more though.

There is an SEC proceeding that was dismissed for lack of a personal benefit, but I think that fits my theory: The alleged insider trading was an investment bank analyst tipping one of his own bank's traders about rating changes. Distinguishing corrupt intent from intent to benefit the bank is difficult there; it seems clear enough to me that the intent was to benefit the bank. And if the analyst intended to benefit the bank, then whom did he misappropriate the information from?

And a jury may even more readily infer conscious avoidance by sophisticated hedge fund managers who can appreciate that accurate inside information about corporate earnings cannot be legitimately obtained, quarter after quarter, without improper disclosure—and whose conduct reveals such awareness.

In related news, consider the Federal Reserve leak case. I don't know all the facts here, but to stylize it a bit, prosecutors are looking into whether someone at the Fed leaked information about Fed deliberations to a macro intelligence firm, Medley Global Advisors, which then passed the information on to its clients, who traded on it. A weird fact in the case is that Medley is claiming to be "a media organization entitled to special protections under the law," just like, for instance, the Wall Street Journal, which also published similar leaked information about the same Fed deliberations.

Why did someone at the Fed (maybe) leak to Medley? Well, why did someone at the Fed (maybe) leak to the Journal? Because Medley or the Journal bribed him? Maybe, but that seems a bit far-fetched. More likely it was some combination of wanting to prepare the market for the Fed's decision, wanting feedback on the Fed's thinking, personal fondness for the journalist asking the question, etc. That is: Whoever leaked this information probably had some more or less public-spirited reason to do so.

Of course the Journal (delivered to lots of subscribers for not that much money) is very different from Medley (delivered, one assumes, to fewer subscribers with more money). But if you're a leaker at the Fed -- as opposed to a hobbyist day-trader -- that difference may seem less relevant to you. If you want to prepare the markets or get informed feedback, Medley's clients may be exactly the people you want to reach -- just like, if you are a company trying to get feedback on a stock buyback program, you will want to talk to your big and/or activist investors, not the dentist with 100 shares.

Such activity also strips investors of confidence that the markets are fair and open. While some “informational disparity is inevitable in the securities markets,” a rational investor will “hesitate to venture ... capital” in a rigged game—one in which he faces a systematic “informational disadvantage” vis-à-vis insiders and their chosen beneficiaries that can never “be overcome with research or skill.”

The evidence established that analysts at hedge funds routinely estimate metrics such as revenue, gross margin, operating margin, and earnings per share through legitimate financial modeling using publicly available information and educated assumptions about industry and company trends. For example, on cross‐examination, cooperating witness Goyal testified that under his financial model on Dell, when he ran the model in January 2008 without any inside information, he calculated May 2008 quarter results of $16.071 billion revenue, 18.5% gross margin, and $0.38 earnings per share. These estimates came very close to Dell’s reported earnings of $16.077 billion revenue; 18.4% gross margin, and $0.38 earnings per share. Appellants also elicited testimony from the cooperating witnesses and investor relations associates that analysts routinely solicited information from companies in order to check assumptions in their models in advance of earnings announcements. Goyal testified that he frequently spoke to internal relations departments to run his model by them and ask whether his assumptions were “too high or too low” or in the “ball park,” which suggests analysts routinely updated numbers in advance of the earnings announcements. Ray’s supervisor confirmed that investor relations departments routinely assisted analysts with developing their models.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
Read more